11 Capital Budgeting Decision Making
Learning Objectives LO
LO1 Determine the payback period for an investment
LO2 Compute the simple rate of return for an investment
LO3 Apply the time value of money concept by computing the present value of a sum of money
LO4 Compute the internal rate of return for an investment
LO5 Evaluate the acceptability of an investment project using the net present value method
LO6 Analyze capital budgeting decision making methods
Capital budgeting decision making
Managers are responsible for many decisions, some with short-term and others with long-term financial consequences. Projects and investments with long-term financial consequences are referred to as capital projects. Therefore, capital budgeting refers to the process of planning projects or making decisions that have a long-term effect on the organization. Examples of capital projects include investments in long-term assets such as vehicles, machines, facilities, or equipment; launching new products or services; and expanding operations.
Capital budgeting decision making is a critical managerial skill. Most organizations have limited resources and more potential capital projects than they can fund. For this reason, managers must be able to evaluate the alternatives and select the project that offers the most benefit to the organization. The ability to choose appropriate capital investments is an essential component of an organization’s long-term financial health and stability.
This chapter discusses four methods for making capital budgeting decisions—the payback period method, the simple rate of return method, the internal rate of return method, and the net present value method.
Payback period LO1
Payback period
The payback period is the length of time that it takes for a project to recover the initial cost from the net cash inflows generated by the project. The payback period is expressed in years. The formula to compute the payback period considers the investment required and the annual net cash inflow from the investment.
Investment required
The required investment is the cost of the project less the trade-in or salvage value received for any assets exchanged in the transaction. For example, assume that Jill decides to purchase a new car for $12,000. She receives $3,000 for trading in her old car. The required investment in the new car is $12,000 – 3,000 = $9,000.
Annual net cash inflow
Annual net cash inflow is the net cash inflows and cash outflows yielded by the investment. Cash inflows have a positive effect on cash, and cash outflows have a negative effect on cash. Revenue and cost savings are cash inflows, whereas expenses and costs are cash outflows. When considering an investment that generates revenue and costs, the annual net cash inflow is cash revenue less cash expenses. For an investment that generates cost savings and costs, the annual net cash inflow is cost savings less cash expenses.
It is important to note that net cash inflow is not the sam